Summers or Yellen? Markets Don’t Care

Aug. 13 (Bloomberg) -- President Barack Obama recently said
that choosing the next chairman of the Federal Reserve is
“definitely one of the most important economic decisions that
I’ll make in the remainder of my presidency.” The financial
media appear to agree, devoting hundreds of column inches to
speculation. Senators, overseas pundits and even Bette Midler
have chimed in.

But there’s one group that considers the decision largely
inconsequential: investors in financial markets. At least,
that’s my initial reading of a revealing natural experiment.

Three weeks ago, Janet Yellen, the current vice chairman of
the Fed, was the heavily backed favorite to get the nod. On July
23, Irish betting site Paddy Power listed her odds at 1-4, which
means that a $4 bet would only return a $1 profit (above the
original stake). Bettors would only take odds like that if they
really believed Yellen’s nomination to be extremely likely. By
contrast, Larry Summers, the president’s former top economic
adviser, was ranked the third-most-likely candidate at 11-2
(behind Roger Ferguson, a former Fed vice chairman, at 5-1).

Now, Summers is a solid 1-2 favorite and Yellen is
perceived as the only real alternative at 2-1. (Ferguson and all
others are now seen as remote possibilities.) The only thing
that has changed in the past three weeks is that details of a
debate within the White House have become public.

Natural Experiment

This episode presents the sort of natural experiment that
whets the appetite of economists. It’s a bit like having the
chance to toss out potential options for a new Fed chief, then
seeing how the financial markets respond. Instead of actually
installing Summers or Yellen, we did so probabilistically,
thanks to a White House leak.

This experiment gives us the opportunity to compare the
assessments of forward-looking investors three weeks ago, when
they expected a Yellen Fed for the next four years, with today,
when they anticipate a Summers-led economy.

Since Washington Post reporter and Bloomberg View columnist
Ezra Klein broke the news on July 23 that Summers is
increasingly viewed as the leading candidate in the White House,
the betting odds for him as the Yellen alternative tumbled from
11-2 to 5-2 on July 30. Yellen remained the favorite, though, at
2-7.

A day later, on July 31, Obama defended Summers in a
closed-door meeting of congressional Democrats. That led the
Summers boom to further intensify in betting markets, and by
Aug. 7, his odds had continued to firm. He is now the clear
betting favorite.

How have financial markets responded to the (probabilistic)
change? Let’s start with inflation expectations. After all, the
inflation rate is the economic indicator for which a Fed chief
is most likely to be held accountable. Moreover, much of the
discussion has revolved around who is the bigger “dove” --
meaning, who is likely to be less focused on keeping inflation
low.

The nearby chart shows a market-based indicator of the
likely inflation rate under the next Fed chairman. It shows the
difference between the yield on a regular five-year U.S.
Treasury bond and a corresponding inflation-indexed bond.

Strikingly, inflation expectations have barely shifted,
even as the fortunes of Summers and Yellen have reversed. That
is, the market appears to expect similar inflation outcomes, on
average, under either one.

The movements in expected inflation, moreover, are tiny
compared with those generated by even small shifts in policy,
such as various statements through late June by the current
chairman, Ben S. Bernanke, about how the Fed would taper its
asset purchases.

Other Factors

If we had futures markets in gross domestic product or the
unemployment rate, we could evaluate whether markets see
differences in those variables, too. Unfortunately, we don’t.
But a very rough indicator of the future of the economy (or at
least a part of it) is captured by stock indexes, and those,
too, have barely shifted. The exchange rate has also been
remarkably stable.

Of course, other factors could be coming into play. Perhaps
traders aren’t paying attention to the Summers-Yellen race. That
seems unlikely, based on even a cursory reading of the financial
news. Perhaps a vigorous market response was obscured by other
economic news that had an offsetting effect on bond yields. This
also seems unlikely given that the past few weeks have been
fairly tranquil, with little competing financial news.

All told, the most likely interpretation is that the
markets judge the Summers-versus-Yellen race as a nonevent. If
so, that would represent a break with history; it is unusual for
financial markets to shrug off changes in central-bank
leadership. Research by Ken Kuttner and Adam Posen shows that
global bond, stock and foreign-exchange markets tend to respond
rather sharply to news about the appointment of new central-bank
chiefs.

Indeed, bond markets were apprehensive prior to the
announcement by President George W. Bush of Bernanke as the new
Fed chief in 2005. Worries over the possibility of a weak Fed
appointment likely reflected Bush’s efforts to name the woefully
underqualified Harriet E. Miers, the White House counsel, to the
U.S. Supreme Court.

So why is this time different? The answer may lie in the
contours of this particular race. The president is thought to be
considering Summers, Yellen and Donald Kohn, also a former Fed
vice chairman. All are outstanding economists with well-established leadership credentials. The important decision Obama
made was in picking his shortlist, and at this point, there are
no bad choices. The similarities among Kohn, Summers and Yellen
overwhelm any differences.

Who will it be? I don’t know. But I’m willing to wager that
financial markets are right to bet that whoever it is will
continue to deliver low and stable inflation.

(Justin Wolfers is a senior fellow of the Brookings
Institution, a professor of economics and public policy at the
University of Michigan and a Bloomberg View columnist.)